Should Travelers Embrace Fluctuating Airfare?

Would you buy an airline ticket that could fluctuate in price after purchase? This is the latest innovation that airlines are considering to battle rising oil prices. Variable price tickets could solve the problem, because they would increase in price as the cost of fuel rises. This way, airlines could charge less money initially, but escape loses later if the price of oil keeps climbing. While it's easy to imagine the consumer backlash that would result when airlines start jacking up the prices of already purchased tickets, variable fares could actually make travelers better off.

This morning on CNBC's Squak Box, Bob Crandall, former chairman and CEO of American Airlines, suggested that airlines should begin considering variable fares as an option. He noted that Allegiant Travel, which owns a low-fare leisure airline in Las Vegas, is considering offering this type of ticket. Last week, the Wall Street Journal reported that the company has notified the Department of Transportation that it wants to sell variable price tickets:

Worried about rising oil prices due to unrest in the Arab world, Allegiant said it would continue offering consumers traditional "locked-in" fares that wouldn't fluctuate. But the airline wants permission to add the option of lower fares that could rise or fall by a preset limit, depending on how much fuel costs change between booking and the trip.

For example, let's say you purchase an airline ticket for $300 in March for a trip in July. If the airline determines that its fuel cost has risen by some specified amount, it may charge you more, perhaps an additional $50, to take the flight. In theory, the ticket could also decline in price -- providing the traveler a partial refund -- if oil prices fall.

The motivation for airlines preferring this sort of ticket is pretty obvious: it covers the risk they face by selling tickets in advance if oil prices rise. Of course, this isn't the only way they could escape this risk. They can also purchase financial derivatives that lock-in fuel prices for some specified period of time. That way, whatever tickets they sell over that time period could have prices based on a definite fuel cost.

The Pros of Fluctuating Tickets

A Fair Price for All

In fact, airlines do purchase such derivatives for this purpose. And while they protect airlines from prices rising, they do not protect consumers from prices remaining constant or falling.

To understand why this is a problem, let's go back to the example above. Imagine if the market predicts that oil prices will rise rapidly over the next four months. So to lock-in oil prices, the airline has to pay some premium to reflect this expectation. Let's say the ticket you buy today costs $400 instead of $300. If, in July, oil prices didn't rise by as much as most analysts anticipated, perhaps the ticket only should have cost $350. The airline would still be protected since they overcharged you for the fuel they overpaid for -- the counterparty on the derivative would have made a profit based on the excessive premium the airline paid. The loser in this equation is the traveler who paid $400 for a ticket that should only have cost $350.

Lower Transaction Costs

There's another added benefit that variable tickets have over derivatives: lower transaction costs. When an airline buys a derivative, it's generally paying for more than just protection from price inflation. These derivatives will build an uncertainty premium into their price. The more muddled future expectations are, the higher the premium airlines must pay. Derivatives will also include fees that go to bankers, traders, and lawyers who create and sell the contracts. Variable price tickets will not include these additional costs.

Cons of Fluctuating Tickets

You Can't Sneak Past Higher Oil Prices

But the flipside would not make consumers as happy. If prices rise more aggressively than the market priced into a derivative, travelers generally benefit if they purchased a ticket in advance. They get to fly at a price below what they should be charged at the time of travel, based on prevailing fuel prices. If their ticket was variable, however, they would be forced to pay more money to cover the higher cost of fuel.

Trust Us: We're the Airlines

Consumers might be cynical about getting refunds when oil prices decline. Airlines are infamous for trying to squeeze every penny possible out of their passengers. Can they really be trusted to provide a fair refund when their fuel costs warrant one? If they're setting the rules on variable price tickets, they can write them to their advantage.

Constant Discomfort

Many consumers may also be uncomfortable with fluctuating prices. Even though the high price of an airline ticket these days may be troubling, it's always a relief to know when a ticket is purchased. If the ticket price continues to fluctuate for weeks or months after purchase, you won't know how much your trip costs until the day of departure.This would be particularly problematic for Americans on a tight budget.

A Mess at the Airport

Moreover, there's the logistical nuisance. You can probably imagine the long lines at an airport for customers paying their additional ticket costs on their day of travel. And what happens if a disgruntled customer refuses to pay a large price increase in the terminal -- does the airline really tell him or her to go home? This problem could be avoided by airlines being authorized to automatically charge (or credit) a traveler's credit card if prices change, but it's pretty plausible that some hiccups would still result.

So although consumers might not love the idea of their ticket price changing, variable pricing could actually make them better off if the pros above end up outweighing the cons. Airlines are sophisticated enough to ensure that they don't lose too much money when oil prices rise, which is why they utilize derivatives. But this protection doesn't always extend to customers. Variable pricing, however, would protect both parties from volatile oil prices.